by Jens Forssbæck

Divergence of risk indicators and the conditions for market discipline
by Jens Forssbæck, Vienna, 2011, ISBN 978-3-902109-59-0

Abstract

Accurate measurement of bank risk is a matter of considerable importance for bank regulation and supervision. Current practices in most countries emphasize reliance on financial statement data for assessing banks' risk. However, the possibility of increased reliance on market-based risk indicators has been a topic for academic and regulatory debate for a long time. Market monitoring of bank risk has typically been tested by regressing market-based risk indicators on various benchmark indicators (such as accounting ratios and credit ratings) to detect whether the market tracks bank risk. This approach overlooks the methodological 'unobservability' problem that testing one imperfect proxy indicator against another, when the true value (in this case, a bank's 'true' risk) is unknown, must yield limited conclusions as to the appropriateness of either indicator – particularly in the event of failure to establish a significant association.